Litigation: Are lawsuits the newest commodity?

Several publications, including The Economist, The Wall Street Journal and Crain’s Chicago Business, have recently highlighted the increase in third-party litigation funding. This attention likely stems from the outsized returns that early entrants are reporting and the arrival of new competitors in the field.

In a third-party funding scenario, outside investors offer to fund a lawsuit in exchange for a share of the payout, which can range from 30 to 60 percent. Such investors run the gamut from hedge funds to more traditional financing sources. Australia andCanadahave already been experiencing a surge in litigation funding, particularly in the class-action arena. In the U.S., the news media and other recent reports suggest that such investments are on the rise.

For instance, a recent Economist article reports that litigation funders are posting “fat returns.” In the article, financial results from two of the publicly traded investors are highlighted. One of the companies earned cash profits of $38 million on $256 million under investment, offering “the highest dividend yield onLondon’s AIM market.” The other publicly traded company “boasts a 61 [percent] net return on invested capital in 2012.” Assuming these results are accurate, it is not surprising that new investors are leaping with both feet into this trend of litigation funding. After all, this is big business.

The early participants in this field have focused primarily on the plaintiff’s side. But at least one new participant, led by former Supreme Court clerks and others with private equity and corporate counsel experience, is reportedly interested in funding the defense side. Essentially, the funding firm in such situations funds a defense based on alternate fee arrangements between the lawyer and client, including a bonus for good results. Presumably, such funding entities have developed a structure by which they receive the return on their investment that withstands the ethical prohibition on fee-sharing with non-lawyers. It’s not readily apparent how they can do so, however.

A Level Playing Field

Proponents of third-party litigation funding claim that such arrangements help level the playing field when one of the litigants has disproportionate means at its disposal with which to fund litigation. Also, companies can keep litigation expenses off their balance sheet and pursue lawsuits that may be cost-prohibitive for a variety of reasons.

Historically, such arrangements were frowned upon and even prohibited under common law doctrines, including maintenance and champerty, which generally prohibited outsiders from taking a share of litigation results, or from even participating in other people’s lawsuits. But those doctrines have largely become a relic of the past, as most lawyers admitted to practice in the past two or three decades are wholly unfamiliar with these concepts.

Moreover, it is not beyond the pale to conclude that outside funding will lead to a proliferation of litigation and encourage frivolous suits. But, according participants quoted in a Wall Street Journal article, the demands of producing a return on an investor’s capital provide a strong disincentive for firms to become involved in suits lacking merit.

Pitfalls to Consider

Another red-flag issue relates to control of the litigation. Certain types of claims cannot be assigned under any circumstances, and a de facto assignment may exist when a party cedes control of the litigation and economic benefits to a third party. This area of jurisprudence is neither well-developed nor completely clear and a party may unexpectedly find itself losing its claim for reasons having no relationship with the merits of the claim. Additionally, real concerns exist regarding potential conflicts between the litigation investors and the actual litigants. The funders’ investment objectives may diverge from the litigation objectives of the real party in interest—differences that could lead to diverging views about litigation tactics and settlement possibilities.

Astronomical litigation costs have a way of driving settlement discussions across a wide spectrum of cases. The prospect of high costs and unpredictable results often leads parties to reach a reasonable business solution. If a piece of litigation is a business venture in and of itself, it is not inconceivable that whoever controls a particular matter—the litigant or the financial investor—may choose to prolong the matter rather than reach a resolution.

Another concern lies in class action suits. Although third-party funding may be helpful, if not crucial, to obtaining recoveries for a class, any recovery will likely be diminished by the return on investment required by the funding source. The absent class members cannot all be consulted in advance about the funding arrangements, which may or may not appear fair in hindsight.

With so many unanswered questions, it is far too early to ascertain the full impact that litigation funding will have on the judicial system in the U.S. But absent legislation or court decisions reviving the long-lost concepts of champerty and maintenance, the outsized returns being reported suggest that litigation funding is here to stay, and will only increase in the future.